Big Picture: “Is it REALLY a Good Time to be Selling Options?”

Big Picture: “Is it REALLY a Good Time to be Selling Options?”
Aug

8

2018

Big Picture: “Is it REALLY a Good Time to be Selling Options?”

Uncertain times: Is it too risky to be investing right now?

A surprising question yields an unexpected answer

I had a new client orientation call last week with a very nice retired couple from Northern California. For the purpose of this letter, I will call them Mr. and Mrs. Smith.

Mr. Smith is a somewhat experienced stock option seller. He was familiar with the results he could generate in stocks and enthusiastic about diversifying the strategy into commodities. Mrs. Smith was a smart lady. But she was not as versed in investing as her husband.

About half way through our getting to know each other, Mrs. Smith abruptly posed a question to me that caught me off guard.

She asked “James, with all that’s going on in the world right now, is it REALLY a Good Time to be Selling Options?”

This took some thought to respond.

However, it occurred to me that this is likely a question many investors – especially those not particularly familiar with option selling – are asking themselves. And it’s a question that anyone investing $1 million + has a right to ask.

I answered Mrs. Smith.

The rest of this month’s opening article is a bit more fleshed out version of my answer to her.

So, Is it a Good Time to be Selling Options?

Mrs. Smith is right. There IS a lot going on in the world right now.

The tariff/trade war issue has many investors spooked.Mid Term Elections are around the corner.Political division in the US is rabid. The national debt continues to spiral, quietly out of the headlines, but out of control none the less. Stocks seem to defy gravity – continuing to hover near record highs.

But consider this. When is there NOT a lot going on in the world? There is ALWAYS a lot going on in the world. And by historical standards, this is pretty tame. Keep in mind that it is the media’s job to make every miniscule issue seem like it’s the ground zero of history. It isn’t.

Graph: Different Strokes

Warning signs? Industrial metals have correlated closely with the S&P for a year but broke sharply when trade tensions heated up. Could stocks follow suit?


Should you be aware of a pending trade war and how it could affect markets? Of course. Buts it’s not the end of the earth. If you want to know what a war looks like, ask those that were around in the early 1940s. I’m sure they can paint some contrasts.

Do we have political division right now? Yes. But ask those that were around in 1968 what political division looks like. You may remember.

All of that being said, the stock market could collapse tomorrow. Some indicators hint there could be something brewing (see illustration above.) The US economy could spin into another 2008 like recession (or worse) in an instant. It would not surprise me.

The point is, we just don’t know. Nobody knows what tomorrow brings.

Which is EXACTLY why diversification of asset class and diversification of strategy are so crucial to growing and protecting a high net worth.

Thus the answer is, YES! Yes, Mrs. Smith, it IS a good time to be selling options. In fact, its ALWAYS a good time to be selling options. But it is especially a good time during times of uncertainty or heightened anxiety.

The Option Seller’s Advantage over Mainstream Investors

Economist are having the equivalent a Hawaiian volcano eruption over the “damage” that tariffs will do the economy. Whether it does, doesn’t or creates some long term good remains to be seen. What is IMPORTANT to understand is that as an option seller, this does not matter to you.

Tariffs could bring China to the negotiating table, resulting in a favorable new trade deal. This could spur markets to new heights. Or – the whole situation could spiral into a full blown trade war, punishing both the US and Chinese economies and stock markets into nose dives.

EITHER WAY – an option seller can prosper, even thrive. Diversification of strategy means the option seller can position for and during bull or bear markets. The mainstream stock investor hopes for a bullish outcome for his holdings. Should it come about, he rejoices in jubilation. And should it not, he sinks in despair. This is much like betting on a football game, uncertain of the outcome.

As an option seller, you do not trust leaving your asset growth or safety to the whims of the market. You can generate yield in either environment. This, I told Mrs. Smith, is a big advantage over mainstream investors and ONE reason why its always a good time to sell options.

Uncertainty – The Option Seller’s Friend

But there is a second, equally important reason why now is a good time to sell options. Mrs. Smith’s concern was that we are in a time of uncertainty. But option sellers thrive in times of uncertainty. Why? Well, you could cite the fact that uncertainty brings volatility which pumps up option premiums. As a general rule, this is true. But one cannot always count on heightened volatility accompanying uncertainty. After all, as we pointed out above, EVERY DAY is a time of uncertainty!


There are very few certainties in life. But one certainty is that the majority of options will continue to expire worthless on expiration day.

No, the bigger point here is that Option Sellers EMBRACE uncertainty. Selling options is, in and of itself, a very rational response to uncertainty. Why? Because as an option seller, you are outright admitting that you are uncertain about the direction of the market. Unlike a stock picker, however, you never have to guess at market direction. You only have to determine a faraway point where there market is unlikely to go, given current information. If it does go there, fine. You lose that one.

But if ANYTHING else happens, you make your profit. You never have to guess at market direction. You never have to try to figure out how a geo-political scenario plays out – and how it will affect the value of your asset. You only have to ascertain the LEAST likely scenario.

There are very few certainties in life. But one certainty is that the majority of options will continue to expire worthless on expiration day.

Uncertainty of geo political outcomes does not change that. This, Mrs. Smith, is exactly why its always a good time to sell options.

Commodities – The Extra Layer of Insulation

Finally, I had to take Mrs. Smith’s question one step further. The question should not be “Is it a good time to be selling options?”

The question should be “Is it a good time to selling options in commodities?”

And my answer that that was an emphatic “YES.”

Why? For all of the reasons mentioned above, of course.

But there is another reason when the question extends to commodities. Once you expand your investment portfolio to include a commodities option component, you not only gain the benefits of diversification of strategy mentioned above.

You also take all of those things, and then move them out of the heavily news influenced stock market into a completely uncorrelated asset class.

You move those assets into an asset class that is less responsive to the whims of daily news and more responsive to individual core supply demand fundamentals.

For instance, most commodities saw some knee jerk selling on days tariffs were announced. But overall trends vary widely. Soybeans, likely in the crosshairs of a trade war, has seen substantial price weakness over the past two months. An option seller could squeeze some nice yield out of that simple observation.

But markets like crude oil and wheat have largely shrugged off any tariff talk – seeing stronger prices resulting from their own unique fundamentals.

Markets like coffee, sugar, or cocoa will likely have little impact at all from a US/China trade war.

Commodities bring a varied bag of uncorrelated products to an investor portfolio, each largely marching to the beat of its own individual supply/demand fundamentals.

And that beat goes on, tariffs or no tariffs.

Should trade tensions start to really cause some trouble in the coming months, expect stocks to move as a whole. It doesn’t matter what stocks you own. If the index goes down, chances are it takes your stocks with it. Mainstream investors tend to move in mass.

Commodities not so much. The price of silver has little to do with the price of cotton. Gasoline prices (featured in this months’ Premium Sniper column on page 4) have little correlation to the price of cocoa or feeder cattle.

Thus, adding them to your portfolio in the context of a direction neutral option selling strategy, brings an extra layer of insulation from Macro – stock influencing events.

Now, does this mean it’s a foolproof way to constant, uninterrupted high returns always and forever?

No.

Does this mean you will never lose money selling an option?

No.

What it does mean is that by diversifying into both uncorrelated strategy and asset class, you bring a sound layer of stabilization to a portfolio. You also target greater consistency and potentially higher, more stable returns – in both “good” and “bad” times. Because, all times are uncertain.

This Mrs. Smith, is why it is ALWAYS a good time to be selling options.

I appreciate you giving your permission for me to use your question in this month’s newsletter. And I hope you understand that I use this not to point out your unfamiliarity or reservations about the strategy. Quite the contrary – I’m glad you asked it as it is likely a question on many an investor mind.

And when you and Mr. Smith come to town, we can discuss the answer further over dinner.

In 24 months, I have a feeling you’ll know the answer for yourself.

Welcome to the firm and to the world of option selling.

And to you my loyal reader, have a great month of writing premium!

Regards,

James

  1. Good comments. Thank you James and Bill for your work and education. Much appreciate and best wishes to your trading!

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